Depositary Receipts (DRs) are negotiable financial instruments that provide domestic investors with a means to invest in foreign companies not traded on domestic exchanges of the investor. DRs are issued by financial institutions and may be redeemed for shares of the underlying foreign business entities they represent. DRs are regularly traded in U.S. and European stock exchanges. Accordingly, DRs can be denominated in U.S. dollars, euros, British pounds, Japanese yen or any other national currency.
Depositary Receipts may be traded in the United States on U.S. stock exchanges. DRs were first introduced in the U.S. in the 1920's in order to streamline the process of investing in business entities not traded on a U.S. exchange. DRs may represent investment in non-U.S. business entities, and, as with other types of DRs, the underlying shares of these non-U.S. businesses. The stock of the underlying non-U.S. businesses is traded on a non-U.S. stock exchange while the DRs themselves trade on a U.S. exchange.
FIG. 1 illustrates a process used by entities to generate and maintain DRs 105. Two financial institutions are generally involved in maintaining DRs 105 on a U.S. stock exchange 110: broker/dealer 115 and a depositary bank 120. The broker/dealer 115 purchases the underlying shares 125 of the foreign business entity and offers them for sale in the U.S. The depositary bank 120 handles the issuance and cancellation of DR certificates 105, backed by the underlying shares held by the investment bank, based on orders 130 placed by investors 145 through brokers 140.
While the underlying shares 125 of the foreign business entity are valued in a foreign currency, the DRs 105 themselves are valued in U.S. dollars. Based on a determined DR ratio, each DR 105 may be issued as representing one or more or a fraction of the underlying shares 125 and the price of each DR 105 will be reflected in the currency in which it is traded. Currency fluctuations have some influence on the U.S. dollar price of the DR 105 because a conversion is needed to compare the price of the DR with the price of the underlying stock. This is because as the foreign currency appreciates the DR appreciates.
To issue a DR 105, the broker/dealer 115 arranges to buy the shares of the non-U.S. business entity on a foreign stock exchange 135 so that the broker/dealer may have the DRs 105 issued on the U.S. stock exchange 140. Accordingly, the DRs 105 may be considered to be repackaged shares, backed by the actual foreign business entity shares 125, but owned by a beneficial owner of the DR investor.
The continual buying and selling of both DRs 105 and the underlying shares 125 on the U.S. stock exchange 110 and the foreign stock exchange 135 works to maintain the prices of the DR 105 and the underlying shares 125 in close parity with one another. Because of this close parity, most DRs 125 are traded by means of intra-market trading.
When a DR 105 is traded, a broker 140 works to find the best price of the underlying shares 125 in question. The broker 140 compares the U.S. dollar price of the DR 105 with the U.S. dollar equivalent price of the underlying share 125 in the home country market 135. If the DR 105 of the underlying share 125 is trading higher then the corresponding quantity of underlying shares 125 (converted from the foreign currency to U.S. dollars), a broker 140 may buy more of the underlying shares 125 and issue DRs 105 on the U.S. market. This action would then, in theory, cause the price of the underlying shares 125 and the price of the DR 105 to reach parity. Therefore, the price of the DRs 105 floats on supply and demand. If the price of the DR 105 is significantly different from the price of the underlying shares 125 in the home country of the foreign business entity (accounting for the currency exchange rate), then an arbitrage opportunity may exist, which is then corrected by the participation of arbitrage investors, who take advantage of the spread and eliminate the opportunity.
A broker 140 may also sell DRs 105 back into the foreign stock exchange 135. This is known as cross-border trading. When this trading occurs, a quantity of DRs 105 is canceled by the depositary bank 120 and a corresponding quantity of the underlying shares 125 are released from the broker/dealer 115.
Types of Depositary Receipts (DRs) include Global Depositary Receipts (GDRs), European Depositary Receipts (EDRs), and International Depositary Receipts (IDRs). DRs are traded on a U.S. stock exchange, such as the New York Stock Exchange (NYSE) or the America Stock Exchange (ASE), GDRs are commonly listed on European stock exchanges such as the London Stock Exchange. Both DRs and GDRs are usually denominated in U.S. dollars, but can also be denominated in euros or other national currencies.